Voodoo Economics: Why you should question the free market zombies who say it is all about "supply and demand."

Beyond "Supply and Demand" 

On Saturday, August 9, 2009, the San Diego Union-Tribune's Business Section ran a lead story by Onell Soto about high gas and oil prices. Mr. Soto is a careful reporter and researcher, and his article quoted me as saying " ... the problem is the low supply of surplus gasoline, which drives up prices." 

I was quoted accurately, but the statement sounds as though I was saying that gas prices are set by the laws of  "Supply and Demand." 

News Flash: They aren't.  Gas prices are set by Refinery Pricing Managers. 

Not only that, but the supply of gasoline that determines these prices can be manipulated.  

Zombies should stop reading here

Explaining all this requires an understanding of how the market works and how prices are set, and a willingness to peel back the corners on cherished American dogma. I'll try and do it  before your eyes glaze over and you take the easy way out by parroting the mainstream dogma in a zombie-like fashion saying ...  it is all about supply and demand ...    it is all about supply and demand ... Ayn Rand is a sex goddess ... the hidden hand of the market place is God-like in its wisdom  etc.

How prices are manipulated

The industry uses two basic tactics to drive up prices. They are retail price redlining, and control of supply. Once you understand how these two factors work, you can stop drinking the free market Kool-Aid offered up by the oil industry.  But the first thing you need to understand is the vital role of unbranded independent gasoline stations.

Unbranded vs. Brand Name gas

There are three types of gas stations: Company-owned gas stations, brand-name gas stations that are owned by a local franchisee, and unbranded gas stations. Company owned stations are vertically integrated (i.e. owned by Shell, supplied by Shell, and managed by Shell). 

Branded Independent Dealers are locked into prices set by the refinery.

Branded dealerships are often owned by local business people who tend to be more inclined to discount their gasoline to their customers.  A branded dealer typically operates a franchise, similar to a Burger King or McDonald's franchise: He or she agrees to follow certain rules in order to sell gas.  It doesn't matter if the station is Shell, Mobil, Chevron, or BP/Arco, if you are selling their gas and displaying their corporate logo you agree to their terms.  Perhaps the most important thing a dealer agrees to is that you will pay whatever the refinery decides to charge you for gasoline (see price redlining below).

Unbranded Independent Dealers can shop around for the cheapest gas

Unbranded dealers are not affiliated with any particular brand of gasoline. These "Indies" buy their gasoline from jobbers who purchase gasoline on the spot market. An unbranded dealer can actually shop around for the best price. 

Gasoline Price Redlining:

Most people assume that local gas prices are set by the local gasoline retailer.  We logically assume that if a gas station is charging 25¢ more per gallon than the same brand a few miles away that it is because the dealer is making an extra 25¢.  This isn't true.

The industry exercises powerful control over local gasoline markets by using a type of price redlining called zone pricing.  With zone pricing, the refinery  sets the price for each dealer depending on the dealer's location.  All oil companies do this. 

The oil industry says it uses zone pricing to "compete" more effectively, but the reality is that  zone pricing has become a powerful tool for controlling the retail price of fuel, for disciplining dealers who price their gasoline too cheaply, and for limiting the damage caused by price wars. 

This is why Refinery Pricing Managers set the price of gasoline instead of allowing the free market to do it for them.  Brand-name dealers are locked into a specific wholesale price for gasoline - a price that can be arbitrarily changed at a moment's notice by the refinery. In fact, the dealer's only real choice is to RAISE the price of fuel - if he or she cuts the price too much, the refinery will simply step in and raise the wholesale price to that specific dealer.

This process, known as "disciplining the dealer" puts more profit in the refiner's pocket and helps turn the branded dealer into a corporate share-cropper.

The refiners can get away  this because the dealer can't shop around for cheaper gasoline. This means the refinery can use its arbitrary prices to prevent price wars and cost-cutting in specific areas. As long as the competition is civil, prices (and oil company profits) will remain high.

In the oil business, everybody hates a cost-cutter.  One of the ways the industry punishes cost-cutters is by "zoning" the price of gasoline more cheaply to stations that are located near a cost-cutter.  In fact, refiners will underprice gasoline in areas where there are cost-cutters and subsidize this activity by overpricing it in areas where competition has been successfully removed, or "tamed." 

So who are these cost-cutting heroes?  It isn't Arco, which generally offers the cheapest name-brand gasoline in California.  And thanks to zone pricing, it isn't always the brand-name stations.  It is the "unbranded independents" and many are more aggressive in their pricing than Arco.

Why Unbranded Independent gas stations are the only real competitors

The most competitive dealers are Unbranded Independents.  Unbranded dealers buy surplus gasoline (usually from a jobber) and pass the savings on to you.  It is that simple ... and also where things get complicated, because these dealers live or die based on the spot price of gasoline.

About 90% of the time, in about 90% of all California markets, the price of gasoline at unbranded stations sets the pace and the price of gasoline in their trade areas.

Unbranded gas stations tend to charge 10 to 15 cents less per gallon than the major brands. Our research shows that one unbranded gasoline station can depress gasoline prices for a five mile radius. 

This is because the major brands are forced to "zone" their gas at cheaper prices to stations that are close to an unbranded independent. 

The fact is, that communities with unbranded gas stations pay less for their gasoline.  In these communities, the primary competition to the unbranded stations is Arco. The reason for this is that the majority of unbranded stations (and 100% of all Arco stations) only accept cash or debit card payments. 

That's why we have referred to Arco, not as a "low-price leader," but rather as a "high price enabler." 

Arco, by default, maintains the price floor for gasoline in California.

Most unbranded dealers have learned that if they price their gasoline more than two cents below the price charged by the nearest Arco, that they risk being "disciplined" as described above. Even retail giants like Costco have learned not to undercut the nearest Arco by more than a few pennies.

The role of the Spot Market in controlling supply

Gasoline refining is a volume business with huge startup costs.  For this reason, the last barrel of gas a refiner produces is the cheapest barrel - at least in terms of manufacturing costs.  As a result, the major refineries tend to produce surplus gasoline in order to make sure that they can supply enough gas to their local dealers.  

This surplus gas often  finds its way onto the spot market, where other companies can buy their gasoline for cash "on the spot."  Local jobbers and dealers will buy this gasoline and sell it at a discount through unbranded outlets.

In a time of surplus, everybody wins .... except for the refineries. For them, selling fuel on the spot market is a little like a farmer growing his own crows.  That's why refiners prefer to NOT sell their excess gasoline on the spot market, because the gasoline is purchased by cost-cutters. And in the oil business, nobody likes a cost-cutter.

Arco, for example, has a long history of shipping gasoline to Japan at a loss in order to keep the price high on the West Coast. 

In a sense, the Los Angeles Spot market serves as a strategic reserve for the industry - when a refinery has a problem and can't produce gasoline, it will buy gasoline at the spot price on the spot market from its colleagues at other refineries (note that I used the word "colleagues" not "competitors").

At the refinery level, the competition for market share between colleagues is civil; not unlike the gentlemanly elbowing of guests at the Sunday after-church crab and lobster buffet.

Sometimes, the refineries avoid dumping their gas on the spot market.

Proof that Refiners prefer cooperation over competition.

In the case of Chevron and British Petroleum/Arco the two companies actually enjoy a pleasant and mutually beneficial trading relationship.  Remember the classic Grey Poupon Mustard commercial where the passenger of a 1958 Rolls Royce Silver Princess pulls up to another Rolls Royce and says "Do you happen to have any Grey Poupon?"  Well, that's pretty much how the refiners treat each other when they run out of gasoline. 

Obviously, with these sorts of supply trading agreements, the wholesale market can't be very competitive.

It is a little like Burger King asking McDonald's to give up some of its beef because Burger King had a splash of the Mad Cow, thank you. 

Remember, the strategy is to keep a tight control over the supply of gasoline. By trading with its alleged competitors, a refiner keeps excess gasoline from reaching the spot market, thereby starving the independent dealers. 

In the unlikely event a refinery can't buy more gasoline from one of its industry chums, it shops the spot market and buys up every barrel it can get its hands on, creating shortages (and FEAR of shortages) which drive prices and profits up.

Both of these factors can drive the price of spot gas up to a level where the unbranded stations can not buy gas at a competitive price.

This raises the price floor by eliminating the only real competitors left in the marketplace.

Fixing Price Manipulation

So how do you fix the problem of price manipulation? Here are five ways:

First:  Lawmakers must outlaw price-redlining and zone pricing.

Second:  Break up the vertically integrated oil industry.

Third:     Ban trading agreements between competitors.

Fourth:   I nspect refineries for safety, and to make certain they are not intentionally shutting down capacity to scare prices higher.

Fifth:      Break up the "oiligarchy."  In 1910, Teddy Roosevelt broke up the Standard Oil Trust.  Now, 100 years later, we need to do it again.

Supply and Demand

A market economy can work, but the laws of Supply and Demand won't work until the oil industry is forced to compete like any other business. An undtil that happens, we'll keep paying through the hose.